Emerging Trend In Financial Risk Management

Posted in Finance Articles, Total Reads: 5390
, Published on 18 December 2011

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Financial Risk Management isan area of finance under much scrutiny, following a series of high-profile failures. How is the financial crisis proving to be a force for change? Key areas of change in Financial Risk Management practices shall naturally derive from the ongoing analyses of the crisis and its roots. Risks, such as market or credit, do not change in nature but evolve with the instruments and purposes they are used for. The way we manage those risks, however, will be entirely different in the near future.

All types of risk exposure like market, credit, legal are interrelated to each other. Liquidity is the ultimate reward or punishment for the sound management . Therefore, liquidity risk emerges as the ultimate operational risk across departments, firms, sectors and even across borders by the regulators themselves.

We have identified four areas of change that will elevate risk policies to strategic priority, executed as a corporate culture hinging on risk management techniques, dynamically implemented throughout the enterprise..

Liquidity risk has become a key factor of concern. Volatility, liquidity and correlations define the backdrop for valuations, sensitivity and tail risks. It's like trying to experiment with a chemical reaction in an unstable environment. The three can no longer be seen as stand-alone sensitivities to be managed: volatility, liquidity and correlations impact each other in a three-dimensional fashion, with highly non-linear and rather unpredictable interdependencies.

Valuation risk stands for managing market and credit risk as a whole after it appeared a firm's credit exposure depends on the assessment and transparency of the market risks of its counterparties and, reciprocally, that cross-asset strategies had turned credit risk exposure into direct market risk for others. Whether it is about measuring collateral value, reporting portfolios' NAV, assessing counterparty exposure or allocating capital, the risks related to data management, models and valuation processes are the true drivers of both market and credit risk exposures

Regulatory risks have been flagged up as some systemic risks arose from leading industrial sectors towards a narrow choice of models and uniform hedging tactics - to some extent, regulatory risks have exposed the industry to the dangers of globalisation.

Risk policies will now be defined and implemented by all firms as part of their business strategy. To be sustainable and truly protect shareholder value, these strategies need to be aligned with each firm's culture, capabilities and true appetite for risks. Firms may chose to expose themselves to risks they cannot really manage, or embark into inappropriate hedging strategy, or risk diversification they can't fully control.

Liquidity, the Ultimate Operational Risk

Liquidity issues seem to derive from the mishandling of risks related to the financial and technical aspects of the trading and banking business, such as funding, portfolio and collateral management, counterparty management, failed settlements, and other operational issues. Therefore, liquidity risk should be considered the ultimate operational risk rather than a stand-alone risk. There are three main causes of liquidity risk:

Market liquidity risk - the risk that assets held in portfolio or pledged as collateral may be mispriced or simply impossible to sell due to adverse market conditions. This is made worse in the world of structured finance with the lack of transparency of the underlying assets; money managers have stopped investing in these assets thereby drying up liquidity.

Funding liquidity risk - the funding and funding costs associated with the lending books. Reflecting the lack of transparency in the industry, banks have limited lending lines in the interbank market leading to a drying up of funds affecting most credit markets.

Counterparty driven liquidity risk - the liquidity risk related to counterparty's unfulfilled obligations, missed or overdue settlements. Causes may stem from financial problems with the counterparty, connectivity failures or especially from data mismanagement. The latter occurs across straight-through processing systems linking risk takers with their execution venues, brokers, custodians and administrators - these systems require complex and frequent database alignment. Failure to process transactions in a timely manner may result in payment failures which, in times of extreme market conditions, can disrupt firm's liquidity management.

Liquidity Risk Mitigation

Mitigating liquidity risk should consist not only of preparing liquidity buffers as a counterbalance, but also requires a fundamental review of risk factors and their alignment with the risk policy of a firm. This is not straight forward as the risk factors a firm is exposed to may not be immediately visible, especially where securitisation and derivatives are involved. It may be necessary for a firm to map all the assets or risk factors underlying the assets under management to fully understand risk exposure and potential concentrations. An in-depth review of actual risk factors, including links with the firm's main customers, sensitivity and concentrations of key assets to those factors and potential correlations among assets, clients and portfolios, are all fundamental to defining the appropriate stress scenarios of each firm Each firm must engineer its own individual response and counterbalancing framework in the context of its own exposure, exposure of its clients, and the nature of the business, and then align it with the approved risk policy. The appropriate prevention and management of liquidity problems should involve a tight monitoring of concentrations.

Banks are traditionally structured to monitor and hedge concentrations within their lending books, thus focusing on funding risk. Buy-side firms are normally required and equipped to monitor and diversify their concentrations within portfolios, so preventing market liquidity risk.

Challenges arise when both the buy-side and sell-side need to tackle cross-asset concentrations to similar risks, when the concentrations are hidden by the derivative nature of the instruments, when funding can be disrupted as a result on market movements changing the value of collateral and when all are impacted by their counterparties' failure to properly handle those risks. It would be difficult to predict all business scenarios that can result in unbalance and disruptions of this sort as they tend to result from unexpected correlation and volatility movements due to unforeseen events. It is possible, however, to tightly monitor exposure concentrations of all kinds, internal and external, as they point out the vulnerabilities of a firm (internal) and even the ones of the entire industry and financial markets (external).

Liquidity Arising from Concentrations

Wealth generating markets, such as stock exchanges or real estate, aggregate liquidity based on the perceived value of the assets traded. Zero-sum game markets, such as futures and options, match customers so that the gain of a trader gain is the loss of another. One macroeconomic role of the former is to absorb or regurgitate liquidity, the latter is a hedging tool for operators with matching exposures to risk factors, such as fluctuations of commodity or currency prices, for example.

A key element to maintaining wealth-generating markets in balance is the different timeframes in which investors operate. What one perceives as a short-term opportunity to sell an asset is seen as a long-term investment by others. The exposure derived from the various investments lead to hedging with zero-sum game markets such as futures and options. Hedges are always arranged for the short term, or rolling from tenant to tenant, due to the risk profiles and settlements they require. Zero-sum markets do not drive trends but can dramatically amplify the short-term price fluctuations of the underlying investments they are derived from.

Speculative bubbles tend to inflate when a large majority of investors trade in a single direction regardless of a timeframe. Risk concentrations form at that point and are particularly likely to trigger liquidity problems as everyone becomes a short-term trader and may exist in panic when the bubble bursts. A definition of a stock market crash is 'the day everyone becomes a short-term trader'. While it would not be possible to predict where and when the next bubble will be created, there are tools to help monitoring risk concentrations build-up and the liquidity risk associated.

Monitoring Concentrations as They Build-up

The key to understanding a firm's vulnerabilities is to uncover the actual risk factors it is exposed to. For example, a firm holding a portfolio of securities exposed (directly or indirectly) to commodity prices would get only a partial view of its risk exposure by running simulations on equity prices only. The potential impact of the underlying commodities on the equities also has an effect. Simulating prices of the underlying equities is also fraught as it relies on many assumptions such as the covariance of the equity versus underlying price returns, the impact on the market volatility and liquidity of extreme market movements, correlations within the industry and so on. In other words, considering the impact of liquidity risk requires monitoring risk exposures at their roots, as much as possible. Each firm should therefore embark in identifying all root-risk factors, monitor the concentrations they build-up and add radical correlation changes in their scenarios.

Price movement and volumes traded give precious indications of potential concentration build-ups as they point out the degree of emotion in which securities or financial instrument are traded. A well-balanced market where buyers meet sellers in steady volume tends to return normally distributed prices and P/L changes, on both short- and medium-term. Before a market loses balances and experiences a massive drawdown, some typical distortions are often noticeable, such as directional volumes imbalance, unexpected changes in correlations, unusual standard deviations, and so on.

Simultaneously, news releases relating to such markets tend to accelerate, new sources of information appear, the market sentiment tends to point to a single direction. The market liquidity may actually be at its highest at such point, but the market gets vulnerable

Conclusion

The essence of Financial Risk management (FRM) is putting in place a clear and systematic process to identify, aggregate and manage risks in the most optimal way. An integrated approach to risk management minimizes transaction costs and more importantly creates confidence in the company’s managers to deal with uncertainties in the environment. But FRM is not easy. It needs a new mindset which encourages people to take calculated risks but not become gamblers. Companies which can implement Financial Risk Management effectively will be able to generate a sustainable competitive advantage and create value for shareholders.

This article has been authored by Nikhil Raj from Indian Institute of Finance.